Elasticity of Demand & Supply

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Transcript of Elasticity of Demand & Supply

Elasticity of Demand & SupplyDemand, Supply & Price DeterminationDefinitionsDeterminantsPriceNon-Price determinantsDiagram RepresentationsMarket EquilibriumEquilibrium PriceEquilibrium QuantityApplicationsWhen there are shifts in Demand and/or Supply, equilibrium quantity and equilibrium price changesBut...How much exactly would equilibrium prices and quantity change by?PEDPESDefinitionFormulaMagnitudeDeterminantsGraphsApplicationsPED for ProducersPED for GovernmentThey use it to evaluate the extent to which a price change would influence Total RevenueThey use it to discourage/encourage consumption of certain goodsAnd to evaluate the responsiveness of consumption due to a price changePricing StrategiesMarketing StrategiesTiming of Decisions on Pricing/MarketingRaising Revenue through TaxationConsumption of a Particular GoodWhy is a fall in supply of housing likely to trigger a larger percentage increase in price than compared to a fall in supply of Cadbury chocolates? Definition of ElasticityElasticity is a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of the determinants, ceteris paribus.

The Price Elasticity of Demand (PED) measures the degree of responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.PED is usually negative

(Recall: Law of Demand)Usually consider the absolute values of PED to compare magnitudesUnits-free measurementThe larger the absolute value, the greater the sensitivity of quantity demanded to a price change = the more price elastic

This is because small percentage increases in its price will take up more of the consumer's available income & hence have a substantial impact on the quantity that consumers are able to purchase.Adjustment Time PeriodThe longer the adjustment period, the more responsive the change in quantity demanded to a given change in price. WHY?

Consumers require time to react and adjust consumption habits & look for alternatives.

Time is required for the development & discovery of new substitutes.HabitWhether demand for a particular good will be relatively price elastic or not depends on the following determinantsH.I.T.S

or

T.H.I.SNumber & Closeness of SubstitutesDefinition of the goodThe number & closeness of substitutes depend on how we define the good.

The more widely defined the good, the lesser the number of substitutes = the lower the value of the PED = the more price inelastic is the demand of the goodThe greater the number of substitutes available for the good, the higher

the price elasticity of demand of the good.

With many close substitutes available, an increase in price of a good will prompt consumers to switch to buying its close substitutes instead

Goods with many close substitutes : price elastic ddGoods with

no close substitutes : price inelastic ddGoods that are habit-forming tend to have a price inelastic demand

Goods that are consumed on a regular basis due to customs, cultures...etc. tend to also have a price inelastic demandRelationship between PED & TRPED and TRPrice Elastic DemandWhen demand is price elastic, quantity demanded will change more than proportionately to a given change in price.Price Inelastic DemandWhen demand is price inelastic, quantity demanded will change less than proportionately to a given price change.Unitary Elastic DemandWhether demand for a particular good will be relatively price elastic or not depends on the following determinantsH.I.T.S or T.H.I.SIf demand is unitary price elastic, then P and Q changes by the same proportion.Point ElasticityPED along a downward sloping linear demand curveSo, how does the knowledge of the responsiveness of quantity demanded to price help us?DefinitionTotal revenue refers to the total receiptsor total earnings received by producersfrom the sale of goods and services.

Total revenue can be calculated simplyas the price of the good (P) multiplied by quantity demanded at that price (Q).

TR = P x Q

Note:

Total Revenue

=

Total ExpenditureHOW?ExamplesWhen price increases, the percentage fall in quantity demanded is proportionately more than the rise in price, thus TR will decrease overall.When price falls, the percentage increase in quantity demanded more than offsets the percentage decrease in price, so TR will rise.When price rises, the percentage fall in quantity demanded is proportionately less than the percentage rise in price, so TR will increase overall.When price falls, the percentage increase in quantity demanded is less than the percentage decrease in price, so TR will fall. E.g. when P falls by 10%, Q rises by 10%and so, TR remains unchanged.All these means that when price changes along different portions of a linear demand curve, total revenue will vary depending on whether the portion is price elastic, inelastic or unitary elastic.Self Assessment 1DefinitionMagnitudeGraphsThe Price Elasticity of Supply (PES) measures the degree of responsiveness of quantity supplied of a good to a change in its price, ceteris paribus.PES is usually positive

F.T.CCost of ProductionThe less the additional costs of producing additional output, the more firms will be encouraged to produce for a given price rise. Time PeriodImmediate Time Period: Highly

Price Inelastic-Depending on availability of stocksFactor MobilityEase at which variable factors can move from one industry use to another.

If factors of production can easily move into or move out of an industry, then the supply of the product of the industry will be more price elastic.Short run: Relatively

Price Inelastic-Depending on availability on raw materialsLong Run: Relatively Price Elastic-Depending on how fast machinery & other fixed factors can be increased.Unstable Prices of Agricultural ProductsPrices of farm products tend to fluctuate widely. Why?Demand for farm products tend to be price inelastic - Lack of substitutesSupply of farm products tends to be price inelastic - Cultivation takes time and agricultural products cannot be stored.Incidence of TaxThe

incidence of tax identifies who ultimately bears the burden of paying the tax.Whether the consumers or producers bear more tax will depend on the PED and PES.Effect of PEDEffect of PESWhat is a subsidy?The benefit of the subsidy is shared between consumers and producers depending on the PED and PES. Consumers benefit by paying a lower market price while producers benefit by receiving a higher market price. Effect of PEDLimitations with the use of elasticity figuresConcepts only look at the responsiveness of quantity demanded and quantity supplied to changes in price of the good itselfCeteris paribus assumptionIn reality, there are many factors affecting demand/supply simultaneouslyFigures are often historical estimates and thus may apply at a certain point in time or for a given group of people. Note: ab > bcProducers receive a greater share of the subsidy when demand is relatively more price elastic than supply(Please write P2 into your diagrams) 

Note: ab  bcConsumers receive a greater share of the subsidy when demand is relatively less price elastic than supply(Please write P2 into your diagrams) 

Self Assessment 5How do you think the share of the benefit of the subsidy will be shared between producers and consumers in the case of:Supply will be price elastic if the firmshave existing spare capacity of variable inputs which allow greater flexibility in supply for firms to respond to increases in pricecan easily store goods at low cost, keeping costs low & adjust more readily when price changes.can easily obtain supplies of extra raw materials where producers will be more responsive to changes in prices of goods.can avoid overtime work where high rates of wages are paid.Self Assessment 2Incidence of Subsidy